What are Mutual Funds? – Advantages | Limitation | Classification

Mutual funds are investment vehicles that pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. This collective investment structure allows individual investors to gain access to a broader range of assets than they might be able to afford or manage on their own.

Table of Contents

1. Concept of Mutual Funds
2. Role of Mutual Funds
3. Investment Objectives of Mutual Funds
4. Investment Policy of Mutual Funds
5. Important Concepts in Mutual Funds
6. Advantages of Mutual Funds
7. Limitations
8. Classification

Check out NISM X Taxmann's Mutual Fund Distributors which covers all important topics to enhance the quality of sales, distribution and related support services in the mutual fund industry. It covers the basics of mutual funds, their role and structure, different kinds of mutual fund schemes and their features, accounting, valuation and taxation aspects underlying mutual funds and their distribution. It also discusses the concept of scheme evaluation and services to investors and prospective investors.

1. Concept of Mutual Funds

A mutual fund is a professionally managed investment vehicle. Practically, one does not invest in mutual fund but invests through mutual funds. However, we hear of “investing in mutual funds” or “investing in mutual fund schemes”. While that is fine for the purpose of discussions, technically it is not correct. As a mutual fund distributor, it is critical to understand the difference between the two concepts.

When someone says that one has invested in a mutual fund scheme, often, the scheme is perceived to be competing with the traditional instruments of investment, viz. equity shares, debentures, bonds, etc. The reality is that one invests in these instruments through a mutual fund scheme. In other words, through investment in a mutual fund, an investor can get access to equities, bonds, money market instruments and/or other securities, that may otherwise be unavailable to them and avail of the professional fund management services offered by an asset management company.

Thus, an investor does not get a different product, but gets a different way of investing. The difference lies in the professional way of investing, portfolio diversification, and a regulated vehicle.

Mutual fund is a vehicle (in the form of a “trust”) to mobilize money from investors, to invest in different markets and securities, in line with stated investment objectives. In other words, through investment in a mutual fund, an investor can get access to equities, bonds, money market instruments and/or other securities, that may otherwise be unavailable to them and avail of the professional fund management services offered by an asset management company.

2. Role of Mutual Funds

The primary role of mutual funds is to help investors in earning an income or building their wealth, by investing in the opportunities available in securities markets. It is possible for mutual funds to structure a scheme for different kinds of investment objectives.

Mutual funds offer different kinds of schemes to cater to the need of diverse investors. In the industry, the words ‘fund’ and ‘scheme’ are used interchangeably. Various categories of schemes are called “funds”. In order to ensure consistency with what is experienced in the market, this workbook goes by the industry practice. However, wherever a difference is required to be drawn, the scheme offering entity is referred to as “mutual fund” or “the fund”.

The money that is raised from investors, ultimately benefits governments, companies and other entities, directly or indirectly, for funding of various projects or paying for various expenses. The projects that are facilitated through such financing, offer employment to people; the income they earn helps them buy goods and services offered by other companies, thus supporting projects of these goods and services companies. Thus, overall economic development is promoted.

As a large investor, the mutual funds can keep a check on the operations of the investee company, and their corporate governance and ethical standards.

The mutual fund industry itself offers livelihood to a large number of employees of mutual funds, distributors, registrars and various other service providers.

Higher employment, income and output in the economy boosts the revenue collection of the government through taxes and other means. When these are spent prudently, it promotes further economic development and nation-building.

Mutual funds can also act as a market stabilizer, in countering large inflows or outflows from foreign investors. Mutual funds are therefore viewed as a key participant in the capital market of any economy. In 2022, when Foreign Portfolio Investors (FPIs) sold heavily in the equity market, Mutual Fund industry provided a counterforce in the form of demand for equity stocks by virtue of fresh inflows into schemes/funds.

3. Investment Objectives of Mutual Funds

Mutual funds seek to mobilize money from all possible investors. Various investors have different investment preferences and needs. In order to accommodate these preferences, mutual funds mobilize different pools of money. Each such pool of money is called a mutual fund scheme.

Every scheme has a pre-announced investment objective. Investors invest in a mutual fund scheme whose investment objective reflects their own needs and preference.

The primary objective of various schemes stems from the basic needs of an investor, viz., safety, liquidity, and returns. Let us look at some examples of investment objectives (Table 1), as taken from the scheme information documents of certain mutual fund schemes.

Table 2.1: Examples of Investment Objectives

As can be seen from the above examples, the investment objectives are a combination of safety, liquidity, and returns (be it regular income or long-term capital appreciation).

It is in line with these objectives that the scheme would decide the investment universe i.e., the types of securities to invest in. As discussed in the previous chapter, different asset classes serve different purposes. Exactly, in the same way, the schemes that seek liquidity invest in money market securities, and those seeking capital appreciation invest in equity.

Mutual fund schemes are often classified in terms of the investment objectives, and often in terms of the investment universe, i.e., where they invest. As can be seen from the discussion above, there is a very close relation between the two types of classifications.

The money mobilized from investors is invested by the mutual fund scheme in a portfolio of securities as per the stated investment objective. Profits or losses, as the case might be, belong to the investors or unitholders. No other entity involved in the mutual fund in any capacity participates in the scheme’s profits or losses. They are all paid a fee or commission for the contributions they make to launching and operating the schemes.

4. Investment Policy of Mutual Funds

Each mutual fund scheme starts with an investment objective. Since mutual funds are investment vehicles that invest in different asset categories, the mutual fund scheme returns would depend on the returns generated from these underlying investments. Hence, once the investment objective is finalised, the mutual fund scheme’s investment policy is arrived at. This is to achieve the investment objective. The investment policy includes the scheme’s asset allocation and investment style.

A mutual fund scheme with the objective of providing liquidity would invest in money market instruments or in debt papers of very short-term maturity. At the same time, a mutual fund scheme that aims to generate capital appreciation over long periods would invest in equity shares. This would reflect in the scheme’s asset allocation, which would be disclosed in the Scheme Information Document (SID). However, even within the same asset category, the fund manager may adopt different styles, e.g., growth style or value style; or different levels of portfolio concentration e.g., focused fund or diversified fund.

The scheme’s investment policy would disclose two aspects–asset allocation and investment style.

5. Important Concepts in Mutual Funds

Units

The investment that an investor makes in a scheme is translated into a certain number of ‘Units’ in the scheme. Thus, an investor in a scheme is issued units of the scheme.

Face Value

Typically, every unit has a face value of Rs. 10. The face value is relevant from an accounting perspective.

Unit Capital

The number of units issued by a scheme multiplied by its face value (Rs. 10) is the capital of the scheme–its Unit Capital.

Recurring Expenses

The fees or commissions paid to various mutual fund constituents come out of the expenses charged to the mutual fund scheme. These are known as recurring expenses. These expenses are charged as a percentage to the scheme’s Assets Under Management (AUM). The scheme expenses are deducted while calculating the NAV. This means that higher the expenses, lower the NAV, and hence lower the investor returns. Given this, SEBI has imposed strict limits on how many expenses could be charged to the scheme. For running the scheme of mutual funds, operating expenses are also incurred.

Net Asset Value

The true worth of a unit of the mutual fund scheme is otherwise called Net Asset Value (NAV) of the scheme. When the investment activity is profitable, the true worth of a unit increases. When there are losses, the true worth of a unit decreases. The NAV is also the net realizable value per unit in case the scheme is to be liquidated–how much money could be generated if all the holdings of the scheme are sold and converted into cash.

Assets Under Management

The sum of all investments made by investors in the mutual fund scheme is the entire mutual fund scheme’s size, which is also known as the scheme’s Assets Under Management (AUM). This can also be obtained by multiplying the current NAV with the total units outstanding. The relative size of mutual fund companies/asset management companies is assessed by their Assets Under Management (AUM). When a scheme is first launched, assets under management is the amount mobilized from investors. Thereafter, if the scheme performs well and is marketed well, its AUM goes up and vice versa.

Further, if the scheme is open to receiving money from investors even post-NFO, then such contributions from investors boost the AUM. Conversely, if the scheme pays any money to the investors, either as a dividend or as consideration for buying back the units of investors, the AUM falls. Dividend option of schemes is now called Income Distribution Cum Capital Withdrawal (IDCW) option.

Mark to Market

The process of valuing each security in the investment portfolio of the scheme at its current market value is called Mark to Market (MTM). The mark-to-market valuation is done on a daily basis for the calculation of daily NAV of a mutual fund scheme. This results in daily fluctuations in the NAVs of all schemes.

6. Advantages of Mutual Funds

Investors Professional Management

Mutual funds offer investors the opportunity to earn an income or build their wealth through the professional management of their investible funds. There are several aspects to such professional management viz. investing in line with the investment objective, investing based on adequate research, and ensuring that prudent investment processes are followed.

Investing in the securities markets will require the investor to open and manage multiple accounts and relationships such as broking account, demat account and others. Mutual fund investment simplifies the process of investing and holding securities.

The fund management function is not restricted to research and selection of securities to construct a portfolio of investments, but also to take care of various administrative tasks like collection of corporate benefits (for example interest payments, dividends, rights issues, buybacks, etc.), or follow-up on the same.

The calculation and publishing of NAV on a daily basis means that the accounting of the entire portfolio is done on a daily basis. The investor managing one’s portfolio independently would need to take too much efforts to take care of this part.

All these benefits come at a very low cost and is available even for the smallest investments. Further, the expenses charged for professional management of funds are quite reasonable.

Affordable Portfolio Diversification

Investing in the units of a scheme provides investors the exposure to a range of securities held in the investment portfolio of the scheme in proportion to their holding in the scheme. Thus, an investor can get proportionate ownership in a diversified investment portfolio even for a small investment of Rs. 500 in a mutual fund scheme.

With diversification, an investor ensures that “all the eggs are not in the same basket”. Consequently, the investor is less likely to lose money on all the investments at the same time. Thus, diversification helps reduce the risk in investment. In order to achieve the same level of diversification as a mutual fund scheme, investors will need to set apart several lakhs of rupees. Instead, they can achieve the diversification through an investment of less than thousand rupees in a mutual fund scheme.

Economies of Scale

Pooling of large sums of money from many investors makes it possible for the mutual fund to engage professional managers for managing investments. Individual investors with small amounts to invest cannot, by themselves, afford to engage such professional management.

Large investment corpus leads to various other economies of scale. For instance, costs related to investment research and office space gets spread across investors. Further, the higher transaction volume makes it possible to negotiate better terms with brokers, bankers and other service providers.

Mutual funds give the flexibility to an investor to organize their investments according to their convenience. Direct investments may require a much higher investment amount than what many investors may be able to invest. For example, an effectively diversified equity portfolio may require a large outlay. Mutual funds offer the same benefits at a much lower investment value since it pools small investments by multiple investors to create a large fund. Similarly, the Income Distribution cum Capital Withdrawal (IDCW) and growth options of mutual funds allow investors to structure the returns from the fund in the way that suits their requirements.

Thus, investing through a mutual fund offers a distinct economic advantage to an investor as compared to direct investing in terms of cost saving.

Transparency

An investor is well served if relevant information is available on time. Availability of such information is critical for making an informed investment decision. The structure of the mutual funds and the regulations by SEBI have ensured that investors get such transparency about their investments. There are three essential places from where the investor can get enough information for making informed decisions, viz., scheme related documents (SID, SAI, and KIM), portfolio disclosures, and the NAV of the scheme. Incidentally, even a prospective investor can access all this information.

Liquidity

At times, investors in financial markets are stuck with a security for which they can’t find a buyer–worse, at times they can’t find the company they invested in. Such investments, whose value the investor cannot easily realize in the market, are technically called illiquid investments and may result in losses for the investor. The bond market in India is wholesale, where transactions take place in very large lot sizes, beyond the reach of the common investor. MFs offer a route for investors to participate, even at a small ticket size.

Investors in a mutual fund scheme can recover the market value of their investments, from the mutual fund itself. Depending on the structure of the mutual fund scheme, this would be possible, either at any time, or during specific intervals, or only on the closure of the scheme. Schemes, where the money can be recovered from the mutual fund only on the closure of the scheme, are compulsorily listed on a stock exchange. In such schemes, the investor can sell the units through the stock exchange platform to recover the prevailing value of the investment.

If a ‘material’ development takes place related to investments in a mutual fund scheme, then such information is made available on time. This helps an investor to take an appropriate action, including taking out the money from a mutual fund scheme. This combination of transparency and liquidity enhances the safety.

Tax Deferral

Mutual funds are not liable to pay tax on the income they earn. If the same income were to be earned by the investor directly, then tax may have to be paid in the same financial year.

Mutual funds offer options, whereby the investor can let the money grow in the scheme for several years. By selecting such options, it is possible for the investor to defer the tax liability. This helps investors to legally build their wealth faster than would have been the case if they were to pay tax on the income each year.

Tax benefits

Specific schemes of mutual funds such as Equity Linked Savings Schemes (ELSS) give investors the benefit of deduction of the amount subscribed up to Rs. 150,000 in a financial year under Section 80C of the Old Tax Regime, from their income that is liable to tax. This reduces their taxable income, and therefore the tax liability.

Convenient Options

The options offered under a scheme allow investors to structure their investments in line with their liquidity preference and tax position.

There are also transaction conveniences like the ability to withdraw only part of the money from the investment account, the ability to invest the additional amount to the account, setting up systematic transactions, etc.

Investment Comfort

Once an investment is made with a mutual fund, they make it convenient for the investor to make further purchases with very little documentation. This simplifies subsequent investment activity.

Regulatory Comfort

The regulator, Securities and Exchange Board of India (SEBI), has mandated strict checks and balances in the structure of mutual funds and their activities. Mutual fund investors benefit from such protection.

Systematic Approach to Investments

Mutual funds also offer facilities that help investors invest amounts regularly through a Systematic Investment Plan (SIP); or withdraw amounts regularly through a Systematic Withdrawal Plan (SWP); or move money between different kinds of schemes through a Systematic Transfer Plan (STP). Such systematic approaches promote investment discipline, which is useful in long-term wealth creation and protection.

7. Limitations

Lack of Portfolio Customization

Some brokerages and asset management firms offer Portfolio Management Services (PMS) to large investors. In a PMS, the investor has better control over what securities are bought and sold on his behalf. The investor can get a customized portfolio in case of PMS.

On the other hand, a unit-holder in a mutual fund is just one of several thousand investors in a scheme. Once a unitholder has bought into the scheme, investment management is left to the fund manager (within the broad parameters of the investment objective). Thus, the unitholder cannot influence what securities or investments the scheme would invest into.

Choice Overload

There are multiple mutual fund schemes offered by several mutual fund houses and multiple options within those schemes which makes it difficult for investors to choose between them. Greater dissemination of industry information through various media and availability of professional advisors or mutual fund distributors in the market helps investors handle this overload.

In order to overcome this choice overload, SEBI has introduced the categorisation of mutual funds to ensure uniformity in characteristics of similar type of schemes launched by different mutual funds. This would help investors to evaluate the different options available before making an informed decision to invest.

No Control Over Costs

All the investor’s money is pooled together in a scheme. Costs incurred for managing the scheme are shared by all the Unitholders in proportion to their holding of units in the scheme. Therefore, an individual investor has no control over the costs in a scheme.

SEBI has however imposed certain limits on the expenses that can be charged to any scheme. These limits, which vary with the size of assets and the nature of the scheme, are discussed later. However, at the same time, it should be noted that the market forces also push the cost down, and there are many schemes that operate at expenses much lower than the limits allowed by the regulator. This aspect turns out to be advantageous for investors.

No Guaranteed Returns

The structure of mutual funds is such that—it is a pass-through vehicle and passes on the risk and return to the fund’s investors. That itself protects the interests of the investors. A mutual fund is not a guaranteed return product. It is just another way of managing money–except that instead of an investor–it is a professional fund management team that takes care of the funds invested. The performance of these investments impacts the returns generated by the mutual fund scheme. The deciding factors are: the movement of the specific market in which the money is invested, the performance of individual securities held and the skills of the investment management team. Out of these, the fund manager can work towards improving one’s skills, but the other factors are out of his control.

8. Classification

Mutual funds can be classified in multiple ways. Funds can be classified based on the investment objective, as discussed earlier. We have different types of mutual fund schemes – growth funds, income funds, and liquid funds. The names of the categories suggest the investment objectives of the schemes. The other ways in which the mutual funds can be classified have been discussed below.

8.1 By the structure of the fund

Mutual fund schemes are structured differently. Some schemes are open for purchase and repurchase on a perpetual basis. Once the scheme is launched, the scheme remains open for transactions, and hence the name of this category of schemes is open-ended funds. On the other hand, some schemes have a fixed maturity date.

This means that these schemes are structured to operate for a fixed period till the maturity date and cease to exist thereafter. Since the closure of the scheme is pre- decided, such schemes are known as close-ended schemes. Apart from these two, there are a couple of other variants, which would be discussed later.

Open-ended funds allow the investors to enter or exit at any time, after the NFO⁶. Investors can buy additional units in the scheme any time after the scheme opens for ongoing transactions. Prospective investors can also buy units. At any time, the existing investors can redeem their investments, that is, they can sell the units back to the scheme to get their money back.

Although some unitholders may exit from the scheme, wholly or partly, the scheme continues operations with the remaining investors. The scheme does not have any kind of time frame in which it is to be closed. The ongoing entry and exit of investors imply that the unit capital in an open-ended fund would keep changing on a regular basis.

When an investor invests money in the scheme, new units would be created and thus the unit balance would increase. On the other hand, when someone exits the scheme (fully or partly), the units sold back to the scheme would be cancelled, due to which the unit balance of the scheme would go down.

Close-ended funds have a fixed maturity. Investors can buy units of a close-ended scheme, from the fund, only during its NFO. The investors cannot transact with the fund after the NFO is over. At the end of the maturity period, the scheme is wound-up, units are cancelled and the money is returned to the investors. The fund makes arrangements for providing liquidity, post-NFO through listing of the units on a stock exchange. Such listing is compulsory for close-ended schemes to provide liquidity to the investors. Therefore, after the NFO, investors who want to buy units will have to find a seller for those units in the stock exchange. Similarly, investors who want to sell units will have to find a buyer for those units in the stock exchange. Since post-NFO sale and purchase of units happen to or from counter- party in the stock exchange–and not to or from the scheme–the unit capital of the scheme remains stable or fixed. Every close ended scheme, other than an equity linked savings scheme, shall be listed on a recognised stock exchange within such time period and subject to such conditions as specified by SEBI.

1. NFO stands for New Fund Offer, or the launch of a mutual fund scheme. This is when the scheme is offered to public for the first time.